The mobile network O2 has suffered a dramatic 33% drop in profitability in its UK business as it battles to retain lucrative iPhone customers.

Until October 2009, O2 was the only network in the UK allowed to sell Apple's smartphone, and many of the high-spending customers which signed two-year contracts around that time are now free to go elsewhere.

In order to hold on to them, the network sacrificed short-term margins for long-term gains. Underlying first quarter operating profit at the Telefónica-owned network dropped 33% year on year to €334m (£276m), which represented an operating margin of 19%, down from 27% for the whole of 2011.

The network tempted customers to stay by subsidising the cost of new smartphones including the iPhone 4S, released in October. Money was ploughed into handset upgrades, which increased 40% year on year, contributing to a 25% rise in commercial costs.

O2 said: "The company's efforts in retaining the customer base have shown positive signs in contract churn which will translate into higher retained value going forward."

Cash spent equipping subscribers with the latest in handset technology resulted in the largest net increase in new contracts since 2010, with 223,000 contract customers added. Exactly half of O2's connections are with contract as opposed to pre-pay customers. Some 41% of its subscribers are smartphone owners, with 80% of new signings choosing these over more basic handsets.

Revenues fell 6% year on year to €1.719bn in the three months to 31 March, "impacted by a difficult trading environment and regulation", the company said. The fall was not as sharp as in the previous quarter, when the 6.8% contraction represented O2's steepest quarterly fall since launch 10 years ago.

Across Europe, the number of subscribers with an internet phone increased 9% to almost 30%. The network had "continued to gain momentum in a highly competitive marketplace", said the European chief executive, José María Alvarez-Pallete.

A day after the EU voted to reduce the price of accessing the internet from a phone while travelling within the region, Telefónica moved to reduce the shock of bills by announcing its first standard pan-European data roaming tariff. Customers can buy 25MB of data – enough for 500 emails or 250 website visits – for €2 a day. The price is below the maximum voted for by the EU, which prohibits networks from charging more than 70 cents for a megabyte, equal to €17.50 for 25MB.